Investment Trust Insider: Aberforth Geared Income's recovery play

When writing aboutHenderson High Income last week I mentioned one of the best performing funds in 2012 (in net asset value terms) has been Aberforth Geared Income – up about 40% year to date.

Its share price, though, is only 102p – marginally ahead of its launch price. As the numbers suggest, Aberforth Geared Income’s performance in its first couple of years has been something of a roller coaster ride, smoothed somewhat by quite a healthy yield.

Volatile discount

The ordinary shares are trading on a discount of more than 10%. The discount has been volatile, trading at asset value and almost out to 15% over the past year. The current discount is not too dissimilar from other competing funds however.

As in other sectors, the UK small cap high income funds trade on a tighter rating than the average UK small cap fund.

Aberforth Geared Income is a split capital trust consisting of ordinary shares and zero dividend preference shares in a ratio of 6:4. It can use bank borrowings but these are limited to 5% of gross assets and gearing will not figure much in the structure.

The trust was formed in April 2010, raising £75 million from investors. In the summer of 2011, it was used as a rollover vehicle for Aberforth Geared Capital & Income Trust and this expanded the trust considerably. It is now a decent size; the ordinary shares have a market cap of £112 million and the zeros £96 million.

Aberforth Geared Income has to repay the zeros on 30 June 2017 and, in theory, the company will wind up after this date, but shareholders should expect Aberforth to try to roll over the assets again nearer the time. The ordinary shares are geared about 1.7 times and will get back at least the money they invested if the assets grow by 3.9% per annum from launch – this is the hurdle rate.

The redemption yield on the zeros was 6.75% at launch and it is now 4.2%. The management fees are slightly unusual. There is no performance fee but the base fee is set at £60,000 (adjusted by RPI from launch) plus 1% of net assets (after deducting the zeros) plus 5% of income. This latter clause gives them some incentive to maximise income generation.

I am surprised that Aberforth Geared Income does not pay quarterly dividends. Instead the board has opted to pay semi-annual dividends in February and August. The trust’s year-end is 30 June. In the first year, it managed an annualised dividend of 5.66p and targeted at least 6p for the second year but managed to pay 6.4p. Aberforth reckons its portfolio should generate 6% per annum dividend growth over the next couple of years.

The trust is benchmarked to the Numis Smaller Companies (ex Investment Companies) Index and defines its investment universe along the same lines as the index, the bottom 10% of the London main market. The portfolio is reasonably diversified – there are 74 holdings in the portfolio and the top 10 is just 28% of the fund.

An eye for value

Aberforth is a value manager and this style bias has a big effect on its performance. Value investing is a trade-off between the cheapness of the rating and the quality of the company. There are times when it will get its stock selection wrong. For example, Game Group, which went into administration in March this year, featured in Aberforth Geared Income’s portfolio. However, over the long term, value investing has been shown to outperform.

The best stocks are often those that other investors have an irrational dislike of. The large cap value managers have benefited as stocks that used to be seen as boring, such as utility companies and pharmaceuticals, have been snapped up by mainstream investors looking for safe havens.

A similar process has been under way in Aberforth’s portfolio. There are still bargains to be had, however. Relative to the index, the portfolio has a bias towards the smaller end of their universe and Aberforth believes this area is so out of favour with investors that it can find companies with strong growth prospects trading at attractive multiples.

Changing fashions

Aberforth Geared Income’s portfolio has a big overweight to industrial stocks and – how fashions change – a large weighting in investment trust companies. By contrast, oil and gas and mining stocks barely feature.

Aberforth publishes quite a lot of useful portfolio analysis. It is interesting to know the stocks in its portfolio derive around half of sales from the UK, with about 20% in Europe and 16% from the US. It is also over-represented in stocks with strong balance sheets.

At the end of June, the trusts stocks traded on an average price to earnings ratio of 10.1 times – 20% cheaper than the average for the benchmark – and yielded 40% more.

Aberforth believes the pendulum remains stuck in favour of growth stocks (as it has been for some time). When it swings back, Aberforth Geared Income will do well.

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